Reserve Bank Governor D. Subbarao has argued that inflation targeting by the RBI is not desirable or practical in India. With inflation running high,India would have been better served if the RBI governor had said precisely the opposite. The country needed to hear him say that inflation control was the dharma of the RBI. This is a time when inflationary expectations need to be anchored,when the country needs to have confidence that something can be done about inflation,and that the RBI will use all the instruments it has to bring inflation down.
Instead,in his C.D. Deshmukh Memorial Lecture in Hyderabad last week the governor gave us a bunch of reasons why he should not,or cannot,bring inflation down. For example,he said,Food items have a weight of 46 to 70 per cent in various CPIs and are notoriously subject to supply shocks which are normally beyond the pale of monetary policy. Yet,in the credit policy speech
he had said that it was non-food,non-fuel inflation that was now running high. Does he accept the responsibility for high non-food,non-fuel inflation?
In that lecture he also said,Should central banks persist with pure inflation targeting? The answer before the crisis was an increasingly confident yes.
Wrong,Mr Governor. Whoever said pure inflation targeting was right? No inflation-targeting central bank gives a weight of one to the inflation coefficient in its Taylor rule. In other words,inflation-targeting central banks are accountable for inflation but employment always matters. Central banks cannot persist with pure inflation targeting because they never practised it.
He said: In an emerging economy like ours,it is not practical for the central bank to focus exclusively on inflation oblivious of the larger development context. The Reserve Bank needs to balance between growth,price stability and financial stability.
Wrong again,Mr Governor. Who said that by doing some inflation targeting one is oblivious to growth? Inflation being ultimately a monetary phenomenon,the central bank should avoid targeting growth. And,playing with the short-run trade-off has bad historical precedents. Low inflation is good for growth.
He asked: Which inflation index do we target? Our headline inflation index is the WPI and that does not,by definition,reflect the consumer price situation. Getting a single representative inflation rate for a large economy with 1.2 billion people,
fragmented markets and diverse geography is a formidable challenge.
Please Mr Governor,why do we care about the WPI rather than the CPIs? Consumer expenditure patterns are heterogeneous in all countries,including those which target inflation. But they still decide to focus on an average of the population or on a specific group (for example,urban consumers in the US). So this argument seems really lame. Say instead: Gosh,I wish I had better statistics on prices. Please CSO,NSSO,move faster and give me better data.
He said: A necessary condition for inflation targeting to work is effective monetary transmission. Our monetary transmission mechanism is improving but is yet to
reach robust standards. It remains impeded because of administered interest rates,the asymmetric contractual relationship between banks and their depositors,illiquid bond markets and large government borrowings. These impediments to monetary transmission diminish our effectiveness as inflation targeters.
Careful,Mr Governor. The RBI has blocked most of the recommendations by many expert committees for development of the bond market. Please allow rather than obstruct,or rather take the lead in pushing for,reforms that improve the monetary policy transmission network.
He said: Finally,large and volatile capital flows will continue to be an important feature of our external sector. Managing these flows will mean managing what has come to be called the impossible trinity balancing between the objectives of a fixed exchange rate,open capital account and independent monetary policy. Inflation targeting is clearly not possible in an impossible trinity situation.
Wrong again,Mr Governor. Every country faces the impossible trinity. India has chosen to open up its capital account. India could also choose to give up a fixed exchange rate. Indeed,for the last one-and-a-half years the rupee has been flexible. Now it is actually possible for the RBI to target inflation.
Subbarao said: The burden of my argument is that the Reserve Bank cannot be,and indeed should not be,a pure inflation targeter. Post-crisis,the dominant view around the world is shaped by the new environment hypothesis which says that flexible inflation targeting,rather than pure inflation targeting,is more efficient. According to this hypothesis,if inflation is way off target,a central banks first call is to bring it within acceptable range,and if inflation is within the range,the central bank should focus on other objectives.
This sounds promising. Will the RBI do something along the lines of inflation targeting,sorry,flexible inflation targeting? Good. The RBI governor should specify what is the target and which measure will be targeted.
And he concluded: To summarise,the answer to the old question,Should central banks be pure inflation targeters? has shifted from an increasingly confident yes to an increasingly qualified yes.
It seems Subbaraos views have slightly changed from February 2010 (www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=471). Then,by pure inflation targeting he meant ignoring financial stability,now he seems to imply that output developments are also ignored. But that is not really the case.
Unfortunately,he also took this opportunity at the Hyderabad lecture to argue that the RBI should be given additional responsibilities over financial stability. A turf battle with the finance ministry on who should be in charge of financial stability is inappropriate when the RBI is unwilling and unable to perform its key function of inflation control. Whether the government chooses to set up an additional coordination mechanism for financial stability or not,the RBI is the monetary authority and the banking regulator,and without any additional titles needing to be given to it,it has the job of working for financial stability. As chairman of the High Level Coordination Committee on financial markets,nothing stops the RBI governor from taking the leadership on coordination for financial stability.
The writer is a professor at the National Institute of Public Finance and Policy,Delhi
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